Bond Market Plunges as Yields Move Sharply Higher

By: Levente_Mady

The bond market traded off for 2 weeks after 8 consecutive weeks of substantial gains. The pullback was sharp, but insignificant relative to the magnitude of the unprecedented move that the long bond futures made over the past 2 months. As expected, once the yearend buying demand was out of the way, the bong bond cracked in a significant fashion. Last week the market faced the same tug of war that is likely to dominate the market going forward: supportive fundamental news countered by increasing supply concerns. During the first full trading week of the year, the bears won the battle in spite of relatively successful Treasury Note auctions.

A fellow by the name of Denis Gartman had an interesting tidbit in his latest commentary. The House Price to Household Income Ratio has hovered around 2.7 times for many decades in the US before it exploded all the way up to 4.6 times by 2006. That ratio is still not cheap at 3.6 times and I expect it will overshoot to well below the 2.7 average before it bottoms. I live in the Promised Land of Vancouver, British Columbia. If you thought 4.6 times was expensive try 13 times in our illustrious city. Yes, that is not a typo, and when I dare voice my opinion that Vancouver real estate is somewhat overpriced, folks look at me like I am from outer space. The average household Income in our city was $77k, while the average house price was within spitting distance of a million bucks half way through 2008. You do the math!

For those real estate owners that don't think the market is expensive round here, I have a couple of questions. Do you think that the 13X ration is justified and sustainable while the world economy implodes? If you answered no, do you think wages will rise or house prices might fall in order to adjust this ratio to more realistic levels? Just to put this in perspective, housing prices might be off as much as 20% since the peak to 800k. Suppose Vancouver is a special place and it deserves a 50% (?) premium over the US – which would put the ratio to 4X Income (versus 2.7X). That would imply that Household Income would need to rise from $77k to $200k – which is not likely to happen with an increasingly weak job scene. And there are 2 more important questions: 1, Do you own your home free and clear (in which case you don't need to worry about being upside down on your mortgage), and have you done anything to protect the largest single investment of your lifetime?

NOTEWORTHY: The economic calendar just keeps getting worse. Construction Spending, Factory Orders and Auto Sales all declined. The ISM Services Survey managed to bounce a couple of points, but the reading of 40 indicates that the service sector continues to contract along with manufacturing. Wee kly Jobless Claims fell well over 100k to 467k over the 2 weeks of holidays. I remain skeptical about the durability of this decline. As a side note, Continuing Claims continue to rise and are not confirming that the sharp drop in Initial Claims signifies a turn in the decaying employment landscape. Consumer Credit declined for the third time in four months.

The monthly Employment report was an unmitigated disaster. Non-farm Payrolls declined 524k and the previous months' figures were revised down another 154k jobs lost. By the time seasonal and birth/death adjustments were backed out, real job losses were closer to 1 million than the original headline figure of 524k. The official Unemployment rate jumped from 6.8 to 7.2% - the highest since 1993. The Canadian economy is also visibly deteriorating. Employment decline 34k while the Unemployment rate jumped .3 to 6.6%. Auto Sales plunged 21%, Home Sales declined marginally, Building permits fell 12% and the Ivey Purchasing Managers Survey fell to 39.1. The economic data is rapidly deteriorating globally, not just in North America . Next week's schedule will include Retail Sales, inflation reports, Industrial Production and the Michigan Consumer Sentiment.

INFLUENCES: Trader surveys tempered their bullish bias but remained bullish than last week. This is negative. The Commitment of Traders reports showed that Commercial traders were net long 284k 10 year Treasury Note futures equivalents – a drop of 66k from 2 weeks ago. This is slightly positive for bonds. Seasonal influences are turning positive again. One item I would still like to see in order to turn wildly bearish: the COT data to show commercials switching from a large long to a short position on the Long Bond contract. They have started paring back but they are still significantly long. The bond market pulled back close to 10$ - a tad more than the 5-6$ correction I was looking for last week. After the violence of the run-up, it is not one bit surprising that this correction was so sharp. In spite of the undeniably supportive fundamental news on the employment front, bonds remained stuck in the mud to close out the week on Friday. The technical picture is damaged, so I don't expect the Long Bond future to recover to the highs over 140.

RATES: The US Long Bond future traded down another 2+ points to close at 133-07 last week, while the yield on the US 10-year note jumped 3 basis points to 2.40%. The Canadian 10 year yield is at 3.80. The US yield curve was steeper as the difference between the 2 year and 10 year Treasury yield moved to 163 basis points, which is a steepening of 8 bps.

BOTTOM LINE: Bond yields were sharply higher, while the yield curve was steepened last week. The fundamental backdrop remains pathetic, which is supportive for bonds. Trader sentiment is exceedingly bullish, Commitment of Traders positions are slightly supportive and seasonal influences are positive. The market has started a corrective phase. My bond market view is slightly negative at this point.

By Levente Mady
lmady@mfglobal.com
www.mfglobal.ca

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